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US inflation – why this time is different

March 13, 2018

By: Tom Goodwin, PhD, senior research director

A classic Aesop’s fable tells the tale of a shepherd boy who repeatedly tricks villagers into thinking wolves are attacking his flock. The villagers start ignoring him after several false rounds of “crying wolf.”

Something similar is going on in the markets at the moment. We have recently had a sharp uptick in volatility and a correction in the equity market. Pundits have been pointing fingers at several factors, but inflation expectations are frequently cited as one of those factors.[1]

Here is where old Aesop becomes current. Since 2008 when the Fed began its program of zero interest rates and quantitative easing, many economists, pundits and politicians have sounded alarms about a coming wave of inflation. It never appeared. In fact, the Fed has struggled to get core inflation up to its 2% target. After years of “crying wolf” it is perhaps natural for many market participants now to ignore any inflation warnings. But remember the end of the tale: a pack of wolves do attack the flock, the shepherd boy sounds the alarm, but the villagers ignore him and the flock is devoured.

The previous inflation concerns were based on widely accepted models of the transmission mechanism between monetary policy and subsequent inflation, according to which such a massive increase in liquidity by the Fed should have led to double digit inflation and interest rates. Fortunately for everyone, the Fed under Ben Bernanke recognized that the financial crisis had left the economy in a condition called a “liquidity trap” and the standard monetary models no longer worked as in the past. The Fed stayed the course and helped bring us out of the recession without inflation.

What is different this time is that the inflation pressure is coming from fiscal policy, not monetary policy. Congress and the President just agreed to an increase in debt-financed government spending by $300 billion over the next two years. This comes on top of a $1.5 trillion tax cut signed into law last December. Historically speaking, this huge fiscal stimulus arrives at an odd time with respect to the stage of the business cycle.[2] Many macro models suggest that this level of stimulus might have done a lot of good five years ago when unemployment was high and industrial capacity was slack, but now US GDP growth is high and rising. Additional demand from government, business and consumers may lead to “cost-push” inflation, where wages and prices of increasingly scarce labor and industrial inputs are bid up without a compensating increase in productivity.

The bond market has noticed. The chart shows that inflation expectations as measured by “breakeven inflation” started edging up in late November when the details of the tax bill became clear and then increased sharply again in early January as the details of the new budget became clear.[3] It has since come off its high of 2.14%, mainly because of a dip in oil prices. This is not yet at alarming levels, but it is higher than it’s been in several years.

Economists aren’t sure how much the tax cut and spending increase will boost growth. But there is concern that inflation will rise above the 2% target and the Fed will have to react. Many economists have now revised their estimates of the number of rate rises in 2018 from three to four.[4]

We are in the midst of a major policy switch. Whereas before monetary policy was pedal-to-the-metal while fiscal policy was neutral to austere, now the roles have reversed. Fiscal policy will inject massive new deficit spending into the US economy this year and next, and monetary policy will have to put the brakes on any inflationary tendencies with higher interest rates. This time really is different.

[3] The compound difference between the yields on the 10 year Treasury note and the 10 year Treasury-Inflation-Protected-Security (TIPS) is known as “breakeven inflation” because it is the 10-year rate of inflation that will produce equal returns from both instruments after adjusting for inflation, if that rate of inflation is realized.

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